Stocks Break Through to Higher Ground

STOCKS RALLIED FOR A FOURTH STRAIGHT week to rise above the top of a trading range they've been mired in all summer, putting the Dow Jones Industrial Average on track for its best September since 1939.

But no one should be surprised if that momentum starts to stall. The market has shimmied up 10% in less than a month on very little provocation. Three out of every four stocks are now straining above their 50-day moving averages, a sharp spike from 25% mere weeks ago. And traders have already begun anticipating Republican gains during the mid-term elections and what they hope might be business-friendlier policies (See Barron'scover story).

Economic cues have stopped deteriorating enough to muzzle the double-dip crowd, but they haven't improved markedly. Sales of existing homes rose 7.7% in August, but hardly erased July's 27% plunge. Mortgage applications have stabilized near their lowest levels this year, but have yet to pick up. Orders for transportation equipment fell 10.3% in August, although businesses spent more on machinery and computers. Demand for construction equipment in Latin America lifted
Caterpillar
(ticker: CAT) shares to a two-year high, but
ConAgra
(CAG) cut its profit forecast, squeezed by rising costs and thriftier shoppers.

Still, a few factors might lend support to the elevated market. Just as investors are becoming more hopeful, Wall Street analysts are becoming skittish. Over the past four weeks, they've raised their forecasts on just 391 stocks within the S&P 1,500, but slashed their marks on 521. Since May, they've steadily tempered their outlooks, except for a brief spell when strong second-quarter profits forced them to momentarily suspend the gloom. This could help companies come October, when they report third-quarter earnings. "The expectations bar has been set substantially lower, so if companies deliver, it could be a strong fall," says Paul Hickey of Bespoke Investment Group.

S&P 500 companies bought back $77.6 billion worth of stock in the second quarter. That's 41% more than the first quarter and 221% higher than the petrified low a year earlier. Buybacks may eventually top $300 billion this year, but that's still a far cry from 2007's $589 billion. "There's still a lot of room for companies to increase buyback activity," says Bespoke's chief market strategist, Mike O'Rourke, "considering the high levels of cash and low levels of interest rates."

Stock buyers haven't thrown caution to the winds, either. Defensive, higher-yielding telecom, utilities and consumer-staple stocks joined cyclical tech companies in the latest surge, and gold ticked above $1,300 a troy ounce Friday. The Dow ended the week up 252, or 2.4%, at 10,860; the four-week streak is its longest since April's market peak. The S&P 500 added 23, or 2.1%, to 1149, its highest close since mid-May. The Nasdaq Composite jumped 66, or 2.8%, to 2381 and is up 14% since early July. The Russell 2000 gained 20, or 3%, to 671.

Goldman Sachs' economists say the risk of recession, the odds of which they put at 25% to 30%, are concentrated in the next six to nine months. That's because "short-cycle" factors that can fluctuate month to month, like inventories and fiscal policy, are deteriorating and no longer boosting the economy, but "long-cycle" factors like bank credit standards and the surplus housing supply continue to slowly mend over time. Says Jan Hatzius: "If the economy muddles through this period, growth is likely to pick up somewhat through the remainder of 2011 as the short-cycle factors stop deteriorating and the long-cycle factors continue to improve."

CALL IT THE INCONVENIENT SIDE of the global economy: U.S. companies are making more money than ever abroad. Alas, that money tends to stay there.

The last time S&P 500 companies sat on this much cash, Elvis was a young artist. But not all that cash can be funneled to hire American employees or buy local equipment. According to Strategas Partners' strategist Nicholas Bohnsack, the portion of S&P 500 revenue earned overseas has swelled to nearly 40% from 30% over the past decade, with the percentage pushing 57% in the tech sector and 54% for energy companies. But foreign profits repatriated back to the U.S. face a 35% corporate tax rate, the second highest in the world after Japan's.

When the American Jobs Creation Act cut the levy on repatriated profits to 5% for 12 months, U.S. companies steered $430 billion back home in 2005. It's debatable how much of that created jobs, but companies used some of it to buy back shares or pay dividends—a boon for investors. That's one reason tech giants like
Cisco Systems
(CSCO) are lobbying for revised repatriation rules, as my colleague Eric Savitz noted recently. But with Washington disinclined toward giving corporations a tax break, Strategas pegs the odds of a rule change as slim unless Republicans take both houses this fall.

This leaves cash-rich corporations to increasingly follow
Microsoft's
(MSFT) lead: raise money in the U.S. by selling bonds at rock-bottom rates, while leaving their foreign cash untouched.

The list of S&P 500 companies with big foreign cash holdings is long and diverse.
Amgen
(AMGN), for instance, has 85% of its $14.5 billion cash position overseas, and
Bristol-Myers Squibb
has 61% of its $7.5 billion on foreign soil. Meanwhile, only 16% of
General Electric's
(GE) cash is outside the country, but GE has a whopping $74 billion in cash. The roster of tech conglomerates with cash holdings of more than $5 billion, half or more of which is abroad, includes Cisco,
Oracle
(ORCL),
Google
(GOOG),
Apple
(AAPL),
Motorola
(MOT), and
Qualcomm
(QCOM).

MICROSOFT, THAT PERENNIAL DISAPPOINT ment, disappointed investors yet again last week when it increased its quarterly dividend by just three miserly pennies to 16 cents. Given its cash-stuffed vaults, investors were expecting much, much more. But what if this increase is just a preview of things?

Unlike the roaring 1990s, Microsoft shares have gone nowhere this decade and have lost a fifth of their value this year alone. The knock on the software behemoth is that its growth is decelerating. Its vast cash stash, which would be a boon at any other company, has become the bane of its existence, signifying to many this cash cow has run out of ideas on how to expand its business.

Lately, this tragic problem of having too much money has gotten worse. Microsoft has $37 billion in its coffers, compared with $6 billion in debt, and its annual free cash flow exceeds $2 a share.

So what is the software giant doing about it? Last week, it went out and raised another $4.8 billion–by selling bonds at some of the lowest rates in corporate history.

In a way, the company is merely milking its AAA credit rating and taking advantage of the clamor for corporate bonds. But with cash already making up 17% of Microsoft's market cap, and earning next to no interest in banks, management surely has plans for it beyond the publicly stated "general corporate purposes."

Raising its quarterly dividend by three pennies marks a 23% increase. This exceeds the 18% rate at which operating income grew recently—a sign, at the very least, that management understands the need to reward long-suffering investors for their patience. Nearly half of Microsoft's cash also is held abroad, some analysts estimate, and last week's bond sale would let Microsoft return more capital to shareholders without repatriating overseas loot.

Like many U.S. companies, Microsoft may just be waiting for Washington to clarify its 2011 tax policies before deciding whether to buy back shares, boost the dividend or hand over a one-time payout. With so many of its shares held by insiders, there is added incentive for management to make stockholders happy—and soon.

The shares might be less compelling if they weren't so cheap. But Microsoft sports a 2.6% yield and trades at just 10.5 times projected 2011 profits—a discount to the 12 average for system-software companies, and to Microsoft's own median 19 multiple over the past decade. Its enterprise value—stock-market capitalization, plus net debt—is just 6.7 times cash flow. That's the lowest ratio in 10 years and well off its high near 24 times, hit in 2001.

Sure, the technology market is uncertain and competition is rife, but investors are valuing Microsoft as if it can't even keep pace with our sluggish GDP growth. Yet Microsoft has boosted yearly profit by double-digits over much of the past decade, and it has the wherewithal to buy back all of its shares within 10 years. Maybe it should.

ANOTHER COMPANY WITH GOBS of cash, and both the means and motivation for rewarding its shareholders, is
Bed Bath & Beyond
(BBBY). Will it return excess capital to shareholders?

The housewares retailer may have bought itself time to delay answering that question by reporting a 34% jump in second-quarter profit last week. Revenue grew by double-digits for the fourth straight quarter, while the company's gross margin ticked up to 41%.

The impressive results didn't dispel investors' concerns, some of which were recently expressed by my colleagues at Barron's Online. The demise of its chief competitor, Linens 'n Things, recently allowed Bed Bath to gain market share, even as it advertised less, but year-over-year comparisons will soon grow tougher. Bed Bath has already wrung what it could from cost cuts, and consumers still aren't spending freely.

These risks, however, are no surprise to investors, and some analysts are nudging down their targets. Despite shrewd management and a debt-free balance sheet, Bed Bath commands no premium to its peers. Its stock is up just 9% this year, trailing gains pushing 50% for home-furnishing retailers, ranging from
Pier 1 Imports
(PIR) to
Williams-Sonoma
(WSM). The shares, near 43, also look subdued by historical standards, fetching just 15 times projected profit, compared with a median of 20 times over the past decade.

Bed Bath's valuation looks even more appealing once you strip out the $1.64 billion— roughly $6.23 a share—of cash on its books. The company also rakes in nearly $3 a share in free cash flow, and directors and executive officers own 5% of its shares. "We remain surprised," notes Credit Suisse analyst Gary Balter, "that this superbly-run retailer, one with significant insider ownership, would shy away from supporting its stock or paying out some of that cash before that option becomes more expensive in 2011." Stay tuned.

What September Selling?

The Dow rallied for a fourth straight week, its longest streak since April's market peak. The blue chips are up 8.4% this month.

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